Forex

Foreign Currency Transactions

The foreign exchange markets are sometimes referred
to as "forex." The forex market is the largest
financial market in the world, with daily average trading
turnover of approximately $1.5 trillion. Operating 24
hours a day, the forex market is highly liquid and most
of the trading is conducted electronically or over the
phone. Banks, insurance companies, large corporations
and other large financial institutions all use the forex
markets to manage the risks associated with fluctuations
in currency rates. In recent years, retail investors
have also looked to the forex markets as yet another
possible investment opportunity.

Kinds Of Major Currencies And Exchange Systems

Major Currencies

The U.S. Dollar

The
United States dollar is the world's main currency. All
currencies are generally quoted in U.S. dollar terms.
Under conditions of international economic and political
unrest, the U.S. dollar is the main safe-haven currency
which was proven particularly well during the Southeast
Asian crisis of 1997-1998.

The U.S. dollar became the leading currency toward
the end of the Second World War and was at the center
of the Bretton Woods Accord, as the other currencies
were virtually pegged against it. The introduction of
the euro in
1999 reduced the dollar's importance only marginally.

The major currencies traded against the U.S. dollar
are the euro, Japanese yen, British pound, and Swiss
franc.

The Euro

The euro was
designed to become the premier currency in trading by
simply being quoted in American terms. Like the U.S.
dollar, the euro has a strong international presence
stemming from members of the European Monetary Union.
The currency remains plagued by unequal growth, high
unemployment, and government resistance to structural
changes. The pair was also weighed in 1999 and 2000
by outflows from foreign investors, particularly Japanese,
who were forced to liquidate their losing investments
in euro- denominated assets. Moreover, European money
managers re balanced their portfolios and reduced their
euro exposure as their needs for hedging currency risk
in Europe declined.

The Japanese Yen

The
Japanese yen is the third most traded currency in the
world; it has a much smaller international presence
than the U.S. dollar or the euro. The yen is very liquid
around the world, practically around the clock. The
natural demand to trade the yen concentrated mostly
among the Japanese keiretsu, the economic and financial
conglomerates.

The yen is much more sensitive to the fortunes of the
Nikkei index, the Japanese stock market, and the real
estate market. The attempt of the Bank of Japan to deflate
the double bubble in these two markets had a negative
effect on the Japanese yen, although the impact was
short-lived.

The British Pound

Until
the end of World War II, the pound was the currency
of reference. Its nickname, cable, is derived from the
telex machine, which was used to trade it in its heyday.
The currency is heavily traded against the euro and
the U.S. dollar, but has a spotty presence against other
currencies. The two-year bout with the Exchange Rate
Mechanism, between 1990 and 1992, had a soothing effect
on the British pound, as it generally had to follow
the Deutsche mark's fluctuations, but the crisis conditions
that precipitated the pound's withdrawal from the ERM
had a psychological effect on the currency.

Prior to the introduction of the euro, both the pound
benefited from any doubts about the currency convergence.
After the introduction of the euro, Bank of England
is attempting to bring the high U.K. rates closer to
the lower rates in the euro zone. The pound could join
the euro in the early 2000s, provided that the U.K.
referendum is positive.

The Swiss Franc

The
Swiss franc is the only currency of a major European
country that belongs neither to the European Monetary
Union nor to the G-7 countries. Although the Swiss economy
is relatively small, the Swiss franc is one of the four
major currencies, closely resembling the strength and
quality of the Swiss economy and finance. Switzerland
has a very close economic relationship with Germany,
and thus to the euro zone. Therefore, in terms of political
uncertainty in the East, the Swiss franc is favored
generally over the euro.

Typically, it is believed that the Swiss franc is a
stable currency. Actually, from a foreign exchange point
of view, the Swiss franc closely resembles the patterns
of the euro, but lacks its liquidity. As the demand
for it exceeds supply, the Swiss franc can be more volatile
than the euro.

Kinds of Exchange Systems

Trading with Brokers

Foreign exchange brokers, unlike equity brokers, do
not take positions for themselves; they only service
banks. Their roles are:
• bringing together buyers and sellers in the
market;
• optimizing the price they show to their customers;
• quickly, accurately, and faithfully executing
the traders' orders.

The majority of the foreign exchange brokers execute
business via phone. The phone lines between brokers
and banks are dedicated, or direct, and are usually
in-stalled free of charge by the broker. A foreign exchange
brokerage firm has direct lines to banks around the
world. Most foreign exchange is executed through an
open box system—a microphone in front of the broker
that continuously transmits everything he or she says
on the direct phone lines to the speaker boxes in the
banks. This way, all banks can hear all the deals being
executed. Because of the open box system used by brokers,
a trader is able to hear all prices quoted; whether
the bid was hit or the offer taken; and the following
price. What the trader will not be able to hear is the
amounts of particular bids and offers and the names
of the banks showing the prices. Prices are anonymous
the anonymity of the banks that are trading in the market
ensures the market's efficiency, as all banks have a
fair chance to trade.

Brokers charge a commission that is paid equally by
the buyer and the seller. The fees are negotiated on
an individual basis by the bank and the brokerage firm.

Brokers show their customers the prices made by other
customers either two-way (bid and offer) prices or one
way (bid or offer) prices from his or her customers.
Traders show different prices because they "read"
the market differently; they have different expectations
and different interests. A broker who has more than
one price on one or both sides will automatically optimize
the price. In other words, the broker will always show
the highest bid and the lowest offer. Therefore, the
market has access to the narrowest spread possible.
Fundamental and technical analyses are used for forecasting
the future direction of the currency. A trader might
test the market by hitting a bid for a small amount
to see if there is any reaction.

Brokers cannot be forced into taking a principal's
role if the name switch takes longer than anticipated.

Another advantage of the brokers' market is that brokers
might provide a broader selection of banks to their
customers. Some European and Asian banks have overnight
desks so their orders are usually placed with brokers
who can deal with the American banks, adding to the
liquidity of the market.

Direct Dealing

Direct
dealing is based on trading reciprocity. A market maker—the
bank making or quoting a price—expects the bank
that is calling to reciprocate with respect to making
a price when called upon. Direct dealing provides more
trading discretion, as compared to dealing in the brokers'
market. Sometimes traders take advantage of this characteristic.

Direct dealing used to be conducted mostly on the phone.
Dealing errors were difficult to prove and even more
difficult to settle. In order to increase dealing safety,
most banks tapped the phone lines on which trading was
conducted. This measure was helpful in recording all
the transaction details and enabling the dealers to
allocate the responsibility for errors fairly. But tape
recorders were unable to prevent trading errors. Direct
dealing was forever changed in the mid - 1980s, by the
introduction of dealing systems.

Dealing Systems

Dealing
systems are on-line computers that link the contributing
banks around the world on a one-on-one basis. The performance
of dealing systems is characterized by speed, reliability,
and safety. Accessing a bank through a dealing system
is much faster than making a phone call. Dealing systems
are continuously being improved in order to offer maximum
support to the dealer's main function: trading. The
software is very reliable in picking up the big figure
of the exchange rates and the standard value dates.
In addition, it is extremely precise and fast in contacting
other parties, switching among conversations, and accessing
the database. The trader is in continuous visual contact
with the information exchanged on the monitor. It is
easier to see than hear this information, especially
when switching among conversations.

Most banks use a combination of brokers and direct
dealing systems. Both approaches reach the same banks,
but not the same parties, because corporations, for
instance, cannot deal in the brokers' market. Traders
develop personal relationships with both brokers and
traders in the markets, but select their trading medium
based on price quality, not on personal feelings. The
market share between dealing systems and brokers fluctuates
based on market conditions. Fast market conditions are
beneficial to dealing systems, whereas regular market
conditions are more beneficial to brokers.

Matching Systems

Unlike
dealing systems, on which trading is not anonymous and
is conducted on a one-on-one basis, matching systems
are anonymous and individual traders deal against the
rest of the market, similar to dealing in the brokers'
market. However, unlike the brokers' market, there are
no individuals to bring the prices to the market, and
liquidity may be limited at times. Matching systems
are well-suited for trading smaller amounts as well.

The dealing systems characteristics of speed, reliability,
and safety are replicated in the matching systems. In
addition, credit lines are automatically managed by
the systems. Traders input the total credit line for
each counter party. When the credit line has been reached,
the system automatically disallows dealing with the
particular party by displaying credit restrictions,
or shows the trader only the price made by banks that
have open lines of credit. As soon as the credit line
is restored, the system allows the bank to deal again.
In the interbank market, traders deal directly with
dealing systems, matching systems, and brokers in a
complementary fashion.

Federal Reserve System of USA
and Central
Banks of Other G-7 Countries

The Federal Reserve System of the USA
Like the other central banks, the Federal Reserve of
the USA affects the foreign exchange markets in three
general areas:
• the discount rate;
• the money market instruments;
• foreign exchange operations.

For the foreign exchange operations most significant
are repurchase agreements to sell the same security
back at the same price at a predetermined date in the
future (usually within 15 days), and at a specific rate
of interest. This arrangement amounts to a temporary
injection of reserves into the banking system. The impact
on the foreign exchange market is that the dollar should
weaken. The repurchase agreements may be either customer
repos or system repos.

Matched sale-purchase agreements are just the opposite
of repurchase agreements. When executing a matched sale-purchase
agreement, the Fed sells a security for immediate delivery
to a dealer or a foreign central bank, with the agreement
to buy back the same security at the same price at a
predetermined time in the future (generally within 7
days). This arrangement amounts to a temporary drain
of reserves. The impact on the foreign exchange market
is that the dollar should strengthen.

The major central banks are involved in foreign exchange
operations in more ways than intervening in the open
market. Their operations include payments among central
banks or to international agencies. In addition, the
Federal Reserve has entered a series of currency swap
arrangements with other central banks since
1962. For instance, to help the allied war effort against
Iraq's invasion of Kuwait in
1990-1991, payments were executed by the Bundesbank
and Bank of Japan to the Federal Reserve. Also, payments
to the World bank or the United Nations are executed
through central banks.

Intervention in the United States foreign exchange
markets by the U.S. Treasury and the Federal Reserve
is geared toward restoring orderly conditions in the
market or influencing the exchange rates. It is not
geared toward affecting the reserves.

There are two types of foreign exchange interventions:
naked intervention and sterilized intervention.

Naked intervention, or unsterilized intervention, refers
to the sole foreign exchange activity. All that takes
place is the intervention itself, in which the

Federal Reserve either buys or sells U.S. dollars
against a foreign currency. In addition to the impact
on the foreign exchange market, there is also a monetary
effect on the money supply. If the money supply is impacted,
then consequent adjustments must be made in interest
rates, in prices, and at all levels of the economy.
Therefore, a naked foreign exchange intervention has
a long-term effect.

Sterilized intervention neutralizes its impact on the
money supply. As there are rather few central banks
that want the impact of their intervention in the foreign
exchange markets to affect all corners of their economy,
sterilized interventions have been the tool of choice.
This holds true for the Federal Reserve as well.

The sterilized intervention involves an additional
step to the original currency transaction. This step
consists of a sale of government securities that offsets
the reserve addition that occurs due to the intervention.
It may be easier to visualize it if you think that the
central bank will finance the sale of a currency through
the sale of a number of government securities.

Because a sterilized intervention only generates an
impact on the supply and demand of a certain currency,
its impact will tend to have a short-to medium-term
effect.

The Central Banks of the Other G-7 Countries

In the wake of World War II, both Germany and Japan
were helped to develop new financial systems. Both countries
created central banks that were fundamentally similar
to the Federal Reserve. Along the line, their scope
was customized to their domestic needs and they diverged
from their model.

The European Central Bank was set up on June 1, 1998
to oversee the ascent of the euro. During the transition
to the third stage of economic and monetary union (introduction
of the single currency on January 1, 1999), it was responsible
for carrying out the Community's monetary policy. The
ECB, which is an independent entity, supervises the
activity of individual member European central banks,
such as Deutsche Bundesbank, Banque de France, and Ufficio
Italiano dei Cambi. The ECB's decision-making bodies
run a European System of Central Banks whose task is
to manage the money in circulation, conduct foreign
exchange operations, hold and manage the Member States'
official foreign reserves, and promote the smooth operation
of payment systems. The ECB is the successor to the
European Monetary Institute (EMI).

The German central bank, widely known as the Bundesbank,
was the model for the ECB. The Bundesbank was a very
independent entity, dedicated to a stable currency,
low inflation, and a controlled money supply. The hyperinflation
that developed in Germany after World War I created
a fertile economic and political scenario for the rise
of an extremist political party and for the start of
World War II. The Bundesbank's chapter obligated it
to avoid any such economic chaos.

The Bank of Japan has deviated from the Federal Reserve
model in terms of independence. Although its Policy
Board is still fully in charge of monetary policy, changes
are still subject to the approval of the Ministry of
Finance (MOF). The BOJ targets the M2 aggregate. On
a quarterly basis, the BOJ releases its Tankan economic
survey. Tankan is the Japanese equivalent of the American
tan book, which presents the state of the economy. The
Tankan's findings are not automatic triggers of monetary
policy changes. Generally, the lack of independence
of a central bank signals inflation. This is not the
case in Japan, and it is yet another example of how
different fiscal or economic policies can have opposite
effects in separate environments.

The Bank of England may be characterized as a less
independent central bank, because the government may
overrule its decision. The BOE has not had an easy tenure.
Despite the fact that British inflation was high through
1991, reaching double-digit rates in the late 1980s,
the Bank of England did a marvelous job of proving to
the world that it was able to maneuver the pound into
mirroring the Exchange Rate Mechanism.

After joining the ERM late in 1990, the BOE was instrumental
in keeping the pound within its 6 percent allowed range
against the deutsche mark, but the pound had a short
stay in the Exchange Rate Mechanism. The divergence
between the artificially high interest rates linked
to ERM commitments and Britain's weak domestic economy
triggered a massive sell-off of the pound in September
1992.

The Bank of France has joint responsibility, with the
Ministry of Finance, to conduct domestic monetary policy.
Their main goals are non-inflationary growth and external
account equilibrium. France has become a major player
in the foreign exchange markets since the ravages of
the ERM crisis of July 1993, when the French franc fell
victim to the foreign exchange markets.

The Bank of Italy is in charge of the monetary policy,
financial intermediaries, and foreign exchange. Like
the other former European Monetary System central banks,
BOI's responsibilities shifted domestically following
the ERM crisis. Along with the Bundesbank and Bank of
France, the Bank of Italy is now part of the European
System of Central Banks (ESCB).

The Bank of Canada is an independent central bank that
has a tight rein on its currency. Due to its complex
economic relations with the United States, the Canadian
dollar has a strong connection to the U.S. dollar. The
BOC intervenes more frequently than the other G7 central
banks to shore up the fluctuations of its Canadian dollar.
The central bank changed its intervention policy in
1999 after admitting that its previous mechanical policy,
of intervening in increments of only $50 million at
a set price based on the previous closing, was not working.

The main advantages
of the FOREX market are:

The largest number of traders
and volumes of transactions

Superior liquidity and speed
of the market: transactions are conducted within a few
seconds according to online quotes

The market works 24 hours a day,
every working days

A trader can open a position
for any period of time he wants

No fees, except for the difference
between buying and selling prices

An opportunity to get a bigger
profit that the invested sum

Qualified work in the FOREX market
can become your main professional activity

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